Economic analysis reported by the Small Business Administration shows[1] that small companies “create more than half of the nonfarm private gross domestic product (GDP)” and “employ just over half of all private sector employees.” That level of economic impact makes encouraging small business economically important to government officials.

Interest in how small business friendly states are has led a number of think tanks to rank states on the favorability of their small business policies. One example is the Small Business and Entrepreneurship Council (SBEC), which put out its Small Business Survival Index 2010[2] earlier this year.

According to the SBEC, South Dakota is the most small business friendly state. And to attract and nurture small business, other states should adopt South Dakota-like policies.

When I read the report, I was surprised. I hadn’t heard a lot of people referring to South Dakota as the latest small business Mecca.

But, the authors of the SBEC report might have figured out why some states have more small business activity than others. So I took a look at how SBEC’s measure of the small business policy friendliness – a metric that “ties together 38 major government-imposed or government-related costs impacting small businesses and entrepreneurs across a broad spectrum of industries and types of businesses” – compares to the level of small business activity in the different states. If the SBEC’s measure was capturing the factors that attract and nurture small businesses, then states that scored the highest on its metric should have the most small business activity.

Specifically, I looked at the correlation of the SBEC measure with the per capita number of establishments with fewer than 500 employees, the per capita number of new small establishments founded in the last year, and the per capita number of small establishments that ceased operations in the previous year, as reported by the SBA’s Office of Advocacy.

The data show a fairly weak relationship – a correlation of 0.24 – between the score on the SBEC measure of policy friendliness and the number of small businesses per capita. Moreover, there was no significant statistical relationship between having a high SBEC score and the rate at which people started small businesses – a correlation of -0.14. Nor was there a relationship between the SBEC score and the rate at which small businesses in the state had closed in the previous year – a correlation of 0.08. Stated differently, states that the SBEC said had a good policy environment for small business did not have more of their population starting or owning small businesses and did not have a lower share of the population closing a small business.

The message of this analysis is clear: while states might have other reasons for wanting to score high on the SBEC’s ranking of small business friendliness, attracting and nurturing small businesses isn’t one of them. Being highly ranked by the SBEC isn’t related to the amount of small business activity in a state, making the SBEC ranking a not-very-useful metric for governors and state legislators interested in identifying policies that are more common in states with more small business activity. After all, the state with the highest rate of small business ownership per capita – Wisconsin – comes in 31st on the SBEC ranking.